Many companies in all sectors of
the economy, and not-for-profit and governmental organizations as well,
allocate service department costs to “production” or user departments, and
ultimately to the products and services that they provide. For example,
hospitals use sophisticated methods for allocating costs of service departments
such as Housekeeping, Patient Admissions, and Medical Records to patient wards
and outpatient services, and then to individual patients. Historically, these
allocations were important to hospitals because Medicare reimbursement was
based on actual costs. To the extent that the hospital allocated service
department costs to Medicare patients, Medicare covered these costs.

Companies that allocate service
department costs do so for one or more of the following reasons:

1.To provide more accurate product cost information.
Allocating service department costs to production departments, and then to
products, recognizes that these services constitute an input in the production
process.

2.To improve decisions about resource utilization. By
imposing on division managers the cost of the service department resources that
they use, division managers are encouraged to use these resources only to the
extent that their benefit exceeds their cost.

3.To ration limited resources. When production
departments have some discretion over their utilization of a service department
resource, charging production departments for the resource usually results in
less demand for it than if the resource were “free” to the production
departments.

The motivation for the first
reason, to provide more accurate product cost information, can be to improve
decision-making within the organization, to improve the quality of external
financial reporting, or to comply with contractual agreements in regulatory
settings where cost-based pricing is used. As discussed above, Medicare was
historically a cost-based reimbursement scheme. As another example, defense
contractors that provide the U.S. military “big ticket” items such as airplanes
and ships often operate under cost-plus contracts, under which they are
reimbursed for their production costs plus a guaranteed profit. In such
settings, the calculation of cost includes a reasonable allocation of overhead,
including overhead from service departments.

The distinction between the
second and third reasons is important in the context of fixed versus variable
costs. In connection with the second reason, to improve decisions about
resource utilization, from the company’s perspective, a division manager making
a short-term decision about whether to utilize service department resources
should incorporate into that decision the service department’s marginal costs,
which are usually the variable costs. The manager should ignore the service
department’s fixed costs if these costs will not be affected by the manager’s
decision. This reasoning suggests that only the service department’s variable
costs should be charged out.

However, in connection with the
third reason, to ration a scarce resource, if the service department controls a
fixed asset, and if demand for the asset exceeds capacity, charging users a fee
for the asset allows the service department to balance demand with supply. The
fee need not relate to the cost of obtaining the asset; rather, it is a
mechanism for managing demand. Examples would be charging departments a “rental
fee” for their use of vehicles from the motor pool, or for their use of a
corporate conference facility.

Service department costs can be
allocated based on actual rates or budgeted rates. Actual rates ensure that all
service department costs are allocated. Budgeted rates provide service
department managers incentives to control costs, and also provide user
departments more accurate information about service department billing rates
for planning purposes. In either case, service department costs should be
allocated using an allocation base that reflects a cause-and-effect
relationship, whenever possible. Here are some examples:

-Allocate building maintenance costs based on square
footage;

-Allocate costs of the company airplane based on miles
flown;

-Allocate costs of the data processing department based
on CPU time.

In some cases, companies benefit
from allocating fixed costs using a different allocation base than variable
costs. For example, fixed costs might be allocated based on an estimate of
long-term usage by the production departments.

Historically, there have been
three alternative methods for allocating service department costs. These
methods differ in the extent to which they account for the fact that service
departments provide services to other service departments as will as to
production departments:

The Direct Method:

The direct method is the most
widely-used method. This method allocates each service department’s total costs
directly to the production departments, and ignores the fact that service
departments may also provide services to other service departments.

Example: Machining and Assembly are the only production departments
that used the services of the Human Resources Department in March. Costs from
Human Resources are allocated based on the number of new hires. Machining hired
seven employees in March and Assembly hired three employees. Human Resources
incurred total costs of $93,000 in March.

The characteristic feature of the
direct method is that no information is necessary about whether any service
departments utilized services of the Human Resources Department. It does not
matter whether no other service department hired anybody, or whether three
other service departments each hired five employees (implying that more than
50% of the hiring occurred in the service departments). Under the direct
method, service department to service department services are ignored, and no
costs are allocated from one service department to another.

The Step-Down Method:

The step-down method is also called the
sequential
method. This method allocates the costs of some service departments
to other service departments, but once a service department’s costs have been allocated,
no subsequent costs are allocated back to it.

The choice of which department to
start with is important. The sequence in which the service departments are
allocated usually effects the ultimate allocation of costs to the production
departments, in that some production departments gain and some lose when the
sequence is changed. Hence, production department managers usually have
preferences over the sequence. The most defensible sequence is to start with
the service department that provides the highest percentage of its total
services to other service departments, or the service department that provides
services to the most number of service departments, or the service department
with the highest costs, or some similar criterion.

Example: Human Resources (H.R.), Data Processing (D.P.), and Risk
Management (R.M.) provide services to the Machining and Assembly production
departments, and in some cases, the service departments also provide services
to each other:

Total Cost

Service

Dept

% of services
provided by the service department listed at left to:

H.R.

D.P.

R.M.

Machining

Assembly

$80,000

H.R.

--

20%

10%

40%

30%

120,000

D.P.

8%

--

7%

30%

55%

40,000

R.M.

--

--

--

50%

50%

$240,000

The amounts in the far left
column are the costs incurred by each service department. Any services that a
department provides to itself are ignored, so the intersection of the row and
column for each service department shows zero. The rows sum to 100%, so that
all services provided by each service department are charged out.

The company decides to allocate
the costs of Human Resources first, because it provides services to two other
service departments, and provides a greater percentage of its services to other
service departments. However, a case could be made to allocate Data Processing
first, because it has greater total costs than either of the other two service
departments. In any case, the company decides to allocate Data Processing
second.

In the table below, the row for
each service department allocates the total costs in that department (the
original costs incurred by the department plus any costs allocated to it from
the previous allocation of other service departments) to the production
departments as well as to any service departments that have not yet been
allocated.

H.R.

D.P.

R.M.

Machining

Assembly

Costs prior to allocation

$80,000

$120,000

$40,000

--

--

Allocation of H.R.

($80,000)

16,000

8,000

$32,000

$24,000

Allocation of D.P.

(136,000)

10,348

44,348

81,304

Allocation of R.M.

(58,348)

29,174

29,174

0

0

0

$105,522

$134,478

After the first service
department has been allocated, in order to derive the percentages to apply to
the production departments and any remaining service departments, it is
necessary to “normalize” these percentages so that they sum to 100%. For
example, after H.R. has been allocated, no costs from D.P. can be allocated
back to H.R. The percentages for the remaining service and production
departments sum to 92% (7% + 30% + 55%), not 100%. Therefore, these percentages
are normalized as follows:

Risk
Management:7% ÷ 92% =7.61%

Machining:30% ÷ 92% =32.61%

Assembly:55% ÷ 92% =59.78%

Total:100.00%

For example, in the table above,
59.78% of $136,000 (= $81,304) is allocated to Assembly, not 55%.

The characteristic feature of the
step-down method is that once the costs of a service department have been
allocated, no costs are allocated back to that service department. As can be
seen by adding $105,522 and $134,478, all $240,000 incurred by the service
departments are ultimately allocated to the two production departments. The
intermediate allocations from service department to service department improve
the accuracy of those final allocations.

The Reciprocal Method:

The reciprocal method is the most
accurate of the three methods for allocating service department costs, because
it recognizes reciprocal services among service departments. It is also the
most complicated method, because it requires solving a set of simultaneous
linear equations.

Using the data from the step-down
method example, the simultaneous equations are:

H.R. = $80,000
+ (0.08 x D.P.)

D.P. = $120,000 + (0.20 x H.R.)

R.M. = $40,000 + (0.10 x H.R.) + (0.07 x D.P.)

Where the variables H.R., D.P.
and R.M. represent the total costs to allocate from each of these service
departments. For example, Human Resources receives services from Data
Processing, but not from Risk Management. 8% of the services that Data
Processing provides, it provides to Human Resources. Therefore, the total costs
allocated from Human Resources should include not only the $80,000 incurred in
that department, but also 8% of the costs incurred by Data Processing. Solving
for the three unknowns (which can be performed using spreadsheet software):

H.R. = $91,057

D.P. = $138,211

R.M. = $58,781

Hence, costs are allocated as
follows:

H.R.

D.P.

R.M.

Machining

Assembly

Costs prior to allocation

$80,000

$120,000

$40,000

--

--

Allocation of H.R.

($91,057)

18,211

9,106

$36,423

$27,317

Allocation of D.P.

11,057

(138,211)

9,675

41,463

76,016

Allocation of R.M.

(58,781)

29,390

29,390

$0

$0

$0

$107,276

$132,723

To illustrate the derivation of
the amounts in this table, the $36,423 that is allocated from Human Resources
to Machining is 40% of H.R.’s total cost of $91,057.

Summary of Service
Department Cost Allocation Methods:

The direct method and step-down method
have no advantages over the reciprocal method except for their simplicity, and
the step-down method is sometimes not very simple. Nevertheless, the reciprocal
method is not widely used. Given advances in computing power, the reciprocal
method would seem to be accessible to many companies that are not using it.
Presumably, these companies believe that the benefits obtained from more
accurate service department cost allocations do not justify the costs required
to implement the reciprocal method. In fact, many companies do not allocate
service department costs at all, either because they do not think these
allocations are beneficial, or because they do not believe that the benefits
justify the costs.

Dysfunctional Incentives
from Service Department Cost Allocations:

The incentives that service
department cost allocations impose on managers and employees should be
carefully considered. In some cases, these allocations have unintended and
undesirable consequences. For example:

1.At one university, professors are “charged” for office
telephone usage, which includes a fixed monthly fee similar to the flat fee
that is charged for residential telephone service. The “charge” comes out of
the professor’s “research allowance,” which can otherwise be used for professional
expenses such as journal subscriptions, professional organization dues, and
travel to conferences. Since the flat fee (as opposed to the long distance
charges) is unavoidable, it does not affect the professors’ behavior, but it is
viewed negatively, because the research allowance is effectively several
hundred dollars a year less than “advertised” by the administration.

2.At another university, state-of-the-art computer
equipment in the classrooms is purchased out of student fees. Consequently, this
equipment is readily available and “free” to the faculty when they teach.
However, when a professor reserves a room for a non-teaching purpose, such as a
research presentation to fellow faculty, the Instructional Technology service
center “charges” the professor’s department approximately $50 to use the
equipment, which is far in excess of the equipment’s marginal cost (the
depreciation on the bulb in the projector). The $50 charge is sufficient to
dissuade many departments from using the equipment for non-instructional
purposes, so the equipment sits idle, and the professors use a “low tech”
solution: an overhead projector and transparencies.